Quick Thoughts: Broadcom’s Fascination with Qualcomm Continues

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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February 6, 2018

Quick Thoughts: Broadcom’s Fascination with Qualcomm Continues

  • AVGO’s fresh bid for QCOM at $82/share seems appropriate in terms of valuation, but the deal remains troubling, due to regulatory uncertainty, questionable strategy, and poor earnings quality.
  • QCOM is moving to complete its own deal for NXP, likely adding $50B or more to AVGO’s $121B offer and straining the likelihood that it can complete the deal.
  • At the same time, reports suggest AAPL may stop buying QCOM modem chips. This is less scary than it sounds – margins on this business are low, AAPL has already shifted half to INTC, and 5G may force AAPL to reconsider.
  • While QCOM shares would drop with the dissolution of the AVGO bid, resolution of its IPR battle with AAPL should drive shares higher. We believe current valuations still underrate QCOM’s opportunities in 5G, automotive, and datacenters.

The QCOM-AVGO soap opera took a fresh turn today when AVGO offered a “best and final” bid for QCOM – $82/share, with $60/share in cash and the rest in AVGO stock. While shareholders were ingesting the ramifications of this new proposition and what it would mean to QCOM’s impending NXP acquisition, reports that AAPL might drop QCOM modem chips entirely hit the tape – suspicious timing given AVGO’s full court press.

The fresh offer from AVGO, valuing QCOM at $121B is 50% premium to QCOM’s trading price on November 2, 2017 when the first bid arrived, and if executed will be the largest technology acquisition ever. From a valuation standpoint, the follow-on offer of $82 seems appropriate, and the potential synergies in an AVGO-QCOM tie up have merit. The combination would lead in most of the silicon in wireless devices, combining AVGO’s strengths in RF, power management, antennae and other parts with QCOM’s dominant modem and System-on-a-Chip franchises. Furthermore, AVGO’s strong datacenter and optics businesses could blend with QCOM’s ambitions for datacenter processors. (http://www.ssrllc.com/publication/quick-thoughts-broadcom-offer-is-another-twist-in-the-qualcomm-soap-opera/) The combined QCOM-AVGO could be a wireless juggernaut benefitting from a growing IOT, connected devices demand and could bring a lot of pressure in negotiating royalty rates with OEM, device manufacturers, hyperscalers etc.

Still there are major issues with the deal. First, the concentration of power in the smartphone market makes us skeptical that the deal could pass scrutiny with regulators, particularly in the EU, with several phone makers already expressing concern. AVGO appears to be offering a $10B breakup fee if the deal is disallowed, but with caveats. Second, QCOM is close to completing its deal for NXP, which would increase the AVGO’s deal price by more than $47B to $160B or more – huge stretch for a company with a current market cap of $93B. It is not clear that AVGO would be able to swing this financing and less clear that QCOM shareholders would be willing to consider a richer concentration of AVGO stock in the deal. Third, QCOM management is very critical of AVGO’s stated strategy for the combined entity. Unilaterally cutting royalty rates seems foolhardy given 72% of QCOM’s profits come from IPR licensing and recent deals with the Chinese Government and Samsung which seem to support the long-term viability of the licensing program. Similarly, hiking prices on QCOM’s chip products brings risk of empowering competition, both from in house designs at customers like Samsung and from Taiwanese rival MediaTek. Finally, we expect QCOM management to make an issue of AVGO’s quality of earnings – EPS has spiked with non-cash write-offs of intangibles from previous deals.

Moreover, we think the ongoing drama with AAPL will eventually be settled in QCOM’s favor. Global patent law relies on precedent for setting fair value, and 25 years of deals with every player in the industry have validated QCOM’s policy of licensing ALL of its patents with one rate, supported by a huge and hugely valuable portfolio of utility patents not restricted by the FRAND requirements for standards -essential IPR. With 5G deployments beginning, we believe AAPL’s tough talk is just talk – it is unlikely that INTC will match QCOM on modems for the new standard, and refusing to buy the better part will only disadvantage AAPL’s own products, at a time when iPhone sales are under pressure.

Purely from a profits standpoint – QCOM reported a handsome quarter a week ago beating topline expectations despite nonpayment by Apple. Even if AAPL doesn’t buy its chips (which we believe QCOM already sells at a low-margin discount for the iPhone), the margin impact would be modest. Even if AAPL’s tactics gain it a 50% cut in its royalty rate – highly unlikely by our reckoning – QCOM would still be due billions of dollars in back royalties and certainty going forward. A worst-case scenario would likely yield a valuation below what AVGO is offering, but the upside scenario seems more than just possible. (Exhibit 1)

Given the risks, we still believe that AVGO’s offer will be rejected and the company will be forced to shop elsewhere to find growth. This does not have to be a bad thing for QCOM shareholders.

Exh 1: QCOM Valuation Summary, February 2018

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